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Brexit: the impact on car retailers

Image thanks to pixabay.com

If you’re in UK motor retailing there will be no escape from the impacts of ‘Brexit’, whatever your political preferences. Depending on the final option negotiated with the EU, auto manufacturers, component suppliers and motor traders and repairers could face significant changes. The challenge for motor traders and repairers in the retail space is to identify the probabilities of each option occurring and the impact of the changes that it or they may bring in the short, medium and longer term. Not an easy task when the negotiators and lobby groups present initiatives and responses which may only be gambits on the path to the final agreement.

Motor dealers and repairers are the final links in some of the most complex global supply chains. Every vehicle manufacturer’s supply chain is likely to see disruption after the UK exits the EU. In the short term this may lead to higher vehicle prices, less reliable parts delivery, new customs procedures, higher VAT and import duties and new regulations for finance and insurance products. All of these changes being accompanied by a period of lower consumer and business confidence and demand. The medium and longer term outlooks are still more opaque. They will depend on the finally agreed trade scenario and how individual brands re-think their investments and distribution footprint in the light of the final trading conditions and their financial impact.

This post – the first in a series – tries to assess the most likely immediate impacts on UK motor dealers and repairers The changes likely to follow in the immediate period after the UK leaves the EU in Spring 2019. A later post will deal with the medium and longer term issues, such as the outlook for Dealer Contracts, Motor Group share prices, Block Exemption Regulations and the Internet, as more clarification emerges.

Existing automotive supply chains between the UK and the EU, and the UK and the rest of the world, were built on the rules of trade agreements going back decades. In the case of the UK and the EU the principles of the last 20 years were, more or less, free movement of people, capital, goods and services. The UK referendum result has threatened to curtail the use of those principles. Alongside them regulatory, VAT and tariff arrangements may also change.

The UK’s trade arrangements with the rest of the world could also be impacted. The assumption that the UK can trade under existing World Trading Organization (WTO) arrangements may not even be technically correct in the immediately after the UK’s exit. Although it is a WTO founder member, existing trade rules for the UK are based on its membership of the EU in many cases. In fact the UK only trades with 24 countries on WTO rules; it trades with 68 non-EU countries under EU negotiated agreements. After Brexit it would need to re-negotiate these as bilateral agreements. However much of an administrative burden this might be, some argue that, as the world’s sixth largest economy, many non-EU countries would be positive about cloning existing EU bilateral trade deals with the UK. Others estimate that, under existing WTO rules the EU would pay more in tariffs to the UK than it collects from it. So, both the UK and the EU have much to gain from a mutually beneficial withdrawal – and much to lose in its absence.

The Three Most Likely Trade Scenarios

EU/UK Trade Options summarized by PWC in 2017.

In the final quarter of 2018 three trade scenarios are emerging. One is more attractive for the EU, another for the UK and a third is, supposedly, equally unattractive to either of the negotiating parties: Scenario 1: New EEA the ‘Norway’ Option – The UK joining the European Economic Area is the EU preferred option and supported by many EU and UK businesses as well as the UK House of Lords. According to Ben Southwood of the Adam Smith Institute, “… the EEA is economic union without political union. So when you are in the EEA you agree to abide by all of the regulations in the single market, and in exchange you have full single market access – including financial passports. But you don’t have to accept your courts being subordinate to higher authorities, the common fisheries policy, and the common agricultural policy, and can sign trade deals with the rest of the world”. Skeptics argue that Southwood is too optimistic. First, the EU negotiators have made it clear that they want concessions in exchange for full access. Second, in the EEA the UK becomes a ‘rule-taker’, not a ‘rule-maker’ and would have to enforce the EU principles and laws. Chatham House point out that, because it keeps the EU ‘Flanking Policies’ in place (which cover areas such as transport, competition, social policy, consumer protection, environment, statistics and company law) it preserves the current status of economic integration, common competition rules, rules for state aid and government procurement. It might be the naturally preferred option for many businesses in complex global supply chains to mitigate short-term disruption but, while the EEA option serves economic interests, it fails to deliver on the prime reasons that forced the referendum itself – UK sovereignty and the core EU principles.

Scenario 2: A New FTA the ‘Canada/CPTPP’ Option – This is the preferred option for the present UK government. The basis for an EU-UK Free Trade Agreement is currently in negotiation but significant obstacles have already emerged from the EU to the UK government proposal, the so-called ‘Chequers Plan revealed in July 2018. The UK plan envisages a ‘hybrid’ version of the EEA and FTA. In simplified terms, for goods it proposes an EEA structure; for services it proposes an FTA. By October 2018 EU negotiators pronounced it unworkable and senior political leaders across the EU muttered that ‘No Deal would be better than a bad deal”. However, reasons for continued optimism remain, if an agreed framework can be found. The EU has over 60 FTA’s already in place, so clearly FTA’s with the EU are possible, and the UK government seems willing to invest considerable political effort to achieve an agreement based on the Chequers Plan. The main blockages concern the EU’s ‘red lines’ concerning timing and status. These have been set out explicitly by the EU Brexit negotiators and inform us all that the EU will not begin substantive discussions until after the withdrawal is complete and the UK has the status of a ‘third-country’. This does not damage the plan as it’s simply presented as the preferred direction of travel for substantive trade talks in the transition phase after withdrawal. So, EU objections might best be viewed as negotiation tactics at this time.

German Corporate Opinion Deloitte June 2018

While both the EU and the UK must persuade political ideologues at home, economic arguments will be decisive in the negotiations. Two results from Deloitte’s ‘Brexit Briefing’ survey of almost 240 large German companies in June 2018 may be important: over 70% of the respondents expected either an FTA for goods, a Customs Union or institutional cooperation to eliminate tariffs. Less than 25% predict a ‘WTO Rules’ Brexit; Although 40% want to maintain access based on the ‘4 Freedoms’, almost 55% expect a continuation of the Single Market without free movement or an FTA. Neither of those options would see tariff barriers in place.

In any event, the UK also faces administrative hurdles before it can sign a binding FTA with any country. Its current membership is ‘bundled’ with the EU and it may be required to complete a WTO accession process before it can negotiate freely as a sovereign state. The UK also needs to adopt and set-up its own independent tariff and customs regime before it can negotiate which tariffs concessions it will make in relation to it. Whatever the final framework the UK has signaled that it will off-set no tariffs for limited access to the EU market and a customs border. However, there may still be payment of the short-term costs of technical barriers to trade (‘TBT”s), such as regulatory compliance for customs clearance (e.g. documents such as Certificates of Origin) and product master data. These could impact on movement of goods for short period after the withdrawal.

Scenario 3: WTO Rules ‘Hard Brexit’ – in public, neither the UK nor the EU want this option to occur. In it the UK trades with the EU on the same basis as any other ‘Third’ country. The EU Common External Tariff (CET) would be imposed on the UK – currently 10% on motor vehicles and roughly 4.5% on components. Import and Export tariffs would also be applied by the UK, new regulations would be required and there would be divergence from many aspects of the existing framework, such as VAT, Documentation requirements and so on. Another ‘Brexit Briefing‘ by Deloitte’s highlights the likely impact on vehicle prices, employment and revenue for German Automotive Supply Chains alone. Some of Deloitte’s conclusions were:

Up to 770,000 fewer cars sold in the UK and EU in 2019 impacting jobs for 14,000 employees

UK cars exported to the EU rise in price by 13%, due to tariffs and devaluation

German and EU cars imported into the UK rise in price by 21%, due to currency appreciation and tariffs

The costs do not stop with tariffs. There will be continuing costs of regulatory requirements. In addition, there may be increased VAT costs (VAT charged on imports) and possible cash flow costs, as firms wait longer for repayments.

‘Post Brexit trade can thrive under WTO rules’ Ruth Lea LSE Jan 2017

RSM, a global financial advisory network, summarized the two competing views of the UK’s future trading prospects outside the EU. Broadly, those arguing for a close relationship with the EU after Brexit point to a weakening of the UK’s bargaining power outside the EU. Their opponents counter that the EU has proven itself slow to make trade deals and that the UK would be more agile in negotiating when opportunities arise.

However, there is convincing evidence that UK trade could advance under WTO rules. Back in 2017 Ruth Lea pointed out that, “over the last decade (2005 – 2015) not only has UK exports to the non-EU grown quicker than with the EU, but UK exports to non-EU countries that have no preferential trade deals with the EU has been buoyant” – see chart.

Recent figures show a similar pattern. Just over 50% of the UK’s exports of goods went to non-EU countries in 2016. Total UK exports of goods were £299BN, of which non-EU goods exports were £156BN, 51% of the UK total exports of goods, according to the Office for National Statistics (ONS). Almost two-thirds of UK service exports went outside the EU in the same year. Exports of services in 2016 were £266BN, of which non-EU exports of services were £168BN, 63% of the UK total exports of services.

What is not clear is how any group of UK politicians can deliver their preferred scenario – see the August 2018 paper from the Institute for Government. Its analysis concluded that, as the negotiating period gets ever shorter, the chance of a WTO Rules scenario increase. Their assessment, however, may only reflect the public statements of individual politicians or bargaining representatives on their preferred options. Political positions may change when they have to vote on a specific trade scenario.

The immediate and short-term impacts of Brexit

Impacts will be felt in Five key areas. Some, such as Sterling Devaluation started immediately after the referendum result was known. Others are expected in the final months of the Article 50 period as the agreed trade scenario direction becomes clear.

1. Sterling Devaluation and Fuel Costs

The Sterling FX rate fell 15% against the Euro and 17% against the USD and AUD on news of the 2016 referendum result. The decline has now stabilized to around 13% of the pre-Brexit Referendum level. Most analysts suggest that the current rate anticipates that, even with a transitional deal with the EU, the UK’s enduring trading terms with the EU will be inferior to those it enjoys as an EU member. However, there is little to suggest further significant falls are likely and there is a possibility that sterling could rise if a favorable trade deal could be agreed with the EU or UK interest rates continue to rise on the back of positive UK economic data. In short, if larger economic issues do not intervene, e.g. a US/EU Tariff War, and, if agreement is reached on an EEA or FTA option, sterling might even rise a little; if the WTO option materializes, sterling is expected to remain near its current levels.

UK Fuel Pump Prices ONS

The direct impact on both the private consumer and fleets of this factor alone will be higher new car, fuel prices and other running costs. This in turn may depress new vehicle sales and, just as importantly, encourage trading down in vehicle models or brands. However, to keep this in perspective: UK Fuel prices at the pump have risen 30% since the start of 2016 and sales in 2016 were the highest on record and were only down 5.6% on that record in 2017.

2. VAT, international trade compliance and customs duties

Under WTO Rules the UK would pay export tariffs on goods it sold abroad and collect import tariffs on goods it bought from abroad. A detailed analysis completed by Civitas summarizes five key points based on 2015 figures:

if the UK leaves the EU without a trade deal UK exporters could face the potential impact of £5.2 billion in tariffs on goods being sold to the EU. However, EU exporters will also face £12.9 billion in tariffs on goods coming to the UK.

Exporters to the UK in 22 of the 27 remaining EU member states face higher tariffs costs when selling their goods than UK exporters face when selling goods to those countries.

German exporters would have to deal with the impact of £3.4 billion of tariffs on goods they export to the UK. UK exporters in return would face £0.9 billion of tariffs on goods going to Germany.

French exporters could face £1.4 billion in tariffs on their products compared to UK exporters facing £0.7 billion. A similar pattern exists for all the UK’s major EU trading partners.

In absolute terms, the biggest impact will be on exports of goods relating to vehicles, with tariffs in the region of £1.3 billion being applied to UK car-related exports going to the EU. This compares to £3.9 billion for the EU, including £1.8 billion in tariffs being applied to German car-related exports.

Deloitte Brexit Briefing July 2018

While consumers ultimately pay the cost of tariffs, the potential impact on demand suggests that manufacturers and distributors may opt to adjust their business model to absorb some of the costs. The Deloitte Brexit Briefing for July 2018, referred to above, estimated the costs for UK, German and EU car prices with the effects of sterling devaluation and import tariffs under WTO rules – see graphic.

In brief, under the FTA and WTO trade scenarios, there will be extra regulatory costs. However, under the WTO trade scenario there will also be import and export duties and VAT to be paid. While the automotive sector will be one of the largest tariff payers in absolute terms this will be a small element of overall revenue. Deloitte estimates that UK new car sales will be lower by 120,000 cars per year than they would have been if Brexit had not happened. They also suggest that British car makers will see the lowest relative price rises, so suffer the least. However, there will still be vehicle and parts price rises and that will reduce overall demand in due course unless mitigating action is taken by brands and distributors.

3. Supply Chain

As soon as the UK leaves the EU at the end of the Article 50 period issues such as rules of origin, customs delays, tariffs and regulatory divergence could impact the automotive supply chain, potentially impacting on car and parts pricing and after sales. In the Financial Times in July 2017, a report pointed out that, if you drive a German-made car, its likely that the power steering came from Germany, the control units from Romania and the shock absorbers from Poland. If the car was British-made half of its average 30,000 components were made abroad. Just as important EU and UK cars exported to third countries avoid tariffs due to EU negotiated FTA’s. After 2020 the UK’s component industry would be seriously disadvantaged if similar FTA’s have not been negotiated by the UK.

Up until the 2016 UK referendum, the supply chain that orchestrated automotive component supply and vehicle distribution was built on a predictable cost model. Under both FTA and WTO rules that cost model will need revision. To avoid import tariffs many more components will need to be sourced in the UK. In 2017 Nissan, BMW, Jaguar Land Rover, Toyota and Vauxhall all invited their ‘Tier 1’ EU component manufacturers to consider building plants in the UK. Nissan launched an initiative to get the UK government to commit to a £100MN fund to assist EU component makers relocate to the UK. However, under WTO rules of origin, at least 50% by value of the product must be UK made to escape tariffs. So, Tier 2 and even Tier 3 suppliers may need to manufacture in the UK to comply. EU ‘rules of origin’ are another complicating issue. To avoid tariffs, EU manufacturers must source 55% of the vehicle in the EU. Without an agreement on EU ‘rules of origin’ for UK components exported to the EU, vehicle makers within the EU may fall under the threshold by sourcing UK parts. To avoid the risk of tariffs EU manufacturers are asking UK component makers to set up in the EU.

Distributors and retailers should plan for disruption of supply in the first 12 to 18 months after Brexit coupled with higher parts prices for all components sourced from Europe. After market chains and repairers may seek to switch to lower cost UK suppliers.

In April 2017 the ACEA described the range of integrated regulations that govern the automotive industry internationally. Many analysts have commented on the issues of regulatory divergence in access to markets. For example, Kieron Laird of the law firm, Gowling WLG, described the impact of Brexit on the “complex web of regulations covering a range of issues including technical standards, safety, vehicle registration, environmental protection and vehicle categorization” and the potential extra costs of meeting two sets of standards, not the current single EU standard. But fewer analysts have reported on the impact of restricted access for financial products. It’s estimated that 80% or more of all UK vehicle registrations are linked to financial products which are traded onward as Asset Backed Securities (“AutoABS”) in the EU and internationally. The ACEA point out that e-passporting for financial services is critical for all captive (manufacturer-owned) finance houses. While no-one argues that access to low cost consumer finance will be as important as tariffs in maintaining vehicle sales, there are ways around the Financial Passport regulations simply be setting up a subsidiary within the EU.

Insurance companies face a similar regulatory and cost hurdle depending on the finally agreed trade scenario which could lead to higher policy premiums. Exit under WTO rules would require them to open new offices inside the EU to continue cross-border trade, adding both a small cost and resource burden. Potentially, US and Far Eastern clients who insure through the UK platform may decide to move their business inside the EU, resulting in a loss of UK income. Finally, with the EU driving regulations, such as Solvency II and the EU Gender Initiative, UK insurers could find themselves encumbered with compliance costs as a ‘rule-taker’. However, under an FTA the UK could achieve regulatory divergence and, in theory, access to the EU markets as this has already been granted to the Swiss Insurance Industry.

5. Brands – Leavers or Stayers

Perhaps the most significant question facing any automotive distributor or authorized repairer is the commitment their brand may have to the UK market post Brexit. in July 2016 PA Consulting described three categories of manufacturers – the leavers, the question marks and the stayers. But, all brands face an uncertain market and financial future in the wake of Brexit under FTA or WTO rules, whether they manufacture in the UK or not?

Brands have to decide on a complex set of market opportunity and cost issues and costs will be impacted by Brexit. Manufacturers ‘typically’ allocate their costs using a formula. The costs incurred

Car Manufacturer Cost Comparison Estimated

directly as a part of manufacturing operations are applied entirely to a single vehicle. Others costs are incurred indirectly in the processes of manufacturing and selling. These indirect costs are recovered by allocating them to each vehicle according to a corporation-specific formula. Because the volumes of sales and production vary widely by model within a manufacturer, the internal calculation of various accounting categories (such as profit or overhead) can vary widely among individual models. The table gives an estimate of the net income of a selected group of manufacturers. These are the summation of the revenue and costs in each market and across all models. With wafer slim margins in some manufacturers, every cost is important. Under WTO rules the UK proportion of Right Hand Drive models will incur extra costs due to tariffs. Manufacturers have many options in managing these costs. In the short term prices may rise or dealer incentives may reduce. In the medium term specifications may be reduced. and model ranges may be narrowed. (For more on these issues, see our earlier posts on ‘Seven Global Car Makers‘)

Conclusions

Should UK dealers and authorized repairers be worried about the immediate impacts of Brexit? A cursory glance through UK motor trade magazines and websites makes it clear that they aren’t – at least not yet. Comments from within the trade show that dealers and after market managers remain focused on short-term issues, such as the impact of online, demand fluctuations, recalls and supply problems. If Brexit does figure in management conversations the discussions seem limited to potential lengthening of vehicle order and parts delivery times.

One reason may be that the likely financial impact on large motor businesses will be limited. The combined global turnover of the Top 10 car makers was $1.64TRN in 2017. The combined impact of EU import/export tariffs is estimated at $6.64BN, a little more that one-tenth of one percent. If the non-franchised global after sales and used car businesses were added in, the financial impact of tariffs would be around a thirtieth of one percent of global revenue.

A second reason may be that the true impacts of Brexit for automotive retail may only emerge in the medium and long term. If the UK begins a new era of economic growth or decline and/or the UK diverges markedly from the EU on issues such as Block Exemption/selective distribution or internet sales, changes may occur at the retail level. If brands start to express a desire to re-write dealer or authorized repairer contracts, either would be a clear signal that significant change may be on its way.